After FTX: Explaining the Difference Between Liquidity and Insolvency

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There’s a brutal liquidity squeeze going on. As central banks withdraw fiat currency from their economies at a rate not seen since the early 1980s, financial institutions that have relied on easy money are finding it hard to survive. The crypto industry is among the worst affected, with company after company experiencing “liquidity crises” that force them to stop withdrawals and cut back lending. But if a “liquidity crisis” is so bad that the company ends up in the bankruptcy courts, the problem is not liquidity – it’s solvency.

A company can recover from liquidity problems, if the business is sound and the assets valuable. Like a plant, watering can get it through a dry spell. But if it is diseased, no amount of water will save it. Lending to a company that is failing because its business model is corrupt and unsustainable is throwing money down the drain. So, it’s important to know whether a failing company is merely suffering from a “liquidity crisis” or is actually insolvent.

Frances Coppola, a CoinDesk columnist, is a freelance writer and speaker on banking, finance and economics. Her book “The Case for People’s Quantitative Easing” explains how modern money creation and quantitative easing work, and advocates “helicopter money” to help economies out of recession.

However, it’s not always easy to distinguish between liquidity and solvency. And it can be convenient for companies to focus only on the short-term cash need and ignore deeper issues. FTX, Celsius Network, BlockFi and Voyager Digital all desperately tried to persuade people to lend them money to keep them going. All of them have ended up in the bankruptcy courts.

To be fair, it is not just crypto companies that say they are merely suffering from a “liquidity crisis” when they are actually insolvent. Traditional financial institutions are just as likely to say everything will be fine if only someone will lend them some more money. For example, RBS, the British bank whose disastrous collapse in October 2008 nearly took down the U.K.’s payments system, insisted it just needed more funding. But it eventually needed a U.K. government bailout costing some 46 billion British pounds (that’s $56.58 billion at today’s exchange rate, but the GBP/USD exchange rate was much higher in October 2008, so the USD equivalent then was about $69 billion).

The confusion between liquidity and solvency is partly caused by the generally accepted definition of “insolvency,” which is “unable to meet obligations as they fall due.” This sounds very much like shortage of cash, i.e., a liquidity crisis. But shortage of cash isn’t necessarily insolvency. Suppose a company that has lots of long-term assets but very little cash is suddenly hit with a margin call on an interest rate swap. It must find more cash in a hurry but, provided there are buyers for its assets or lenders willing to advance cash against its assets, it can meet its obligations. It is not insolvent.

Read more: Frances Coppola – Crypto’s 1907 Moment

But suppose the company’s assets mainly consist of a large pile of claims on other companies that are also experiencing “liquidity crises” and have as a result defaulted on their obligations. No one is going to buy those assets, and no one is going to lend any money against the security of those assets either. So the company cannot meet its obligations. It is insolvent. As, of course, are the other companies. This is what happens in systemic crises like the one that has engulfed the crypto world. Voyager’s claims on Three Arrows Capital made up over a quarter of its assets: When Three Arrows failed, those assets became effectively worthless. Three Arrows Capital was itself rendered insolvent by the collapse of Terra. When companies are connected by chains of claims, the insolvency of one company can result in domino-like collapses across an entire industry.

Balance sheets that contain large amounts of “intangible assets” – things you can’t kick – are most likely to end up catastrophically insolvent. Crypto companies with balance sheets full of their own issued tokens, for example. Or conventional conglomerates that have overpaid for acquisitions and ended up with a balance sheet full of unrealizable future cash flows from those acquisitions – what accountants call “goodwill.” Goodwill evaporates in insolvency. So does the value of tokens.

But Sam Bankman-Fried insisted that FTX failed because of a “run on the bank.” So what are bank runs? Are they merely liquidity crises or are they insolvency?

Contrary to popular opinion, so-called “fractional reserve” banks are not generally insolvent. Their assets exceed their liabilities: In banking parlance, the difference between the two is known as “capital,” and for licensed banks the size and composition of that difference is governed by capital regulations. The problem is that most of their liabilities must be repaid on demand, but their assets mainly consist of a pile of long-term loans and securities that can’t be called and might not easily be sold or pledged for cash either. So they are chronically short of cash. If depositors all try to withdraw their deposits at the same time, fractional reserve banks can literally run out of money.

Read more: David Z. Morris – FTX’s Collapse Was a Crime, Not an Accident

“Reserve requirements” aim to ensure that banks have sufficient cash on hand to meet the normal daily volume of deposit withdrawals, but they aren’t intended to cope with bank runs. So licensed banks that experience runs can, as a last resort, borrow cash from central banks against the security of their assets. There’s a caveat – the bank must be solvent. The “Bagehot Principle” says that in a financial crisis a central bank should lend freely, at a penalty rate, to solvent firms, in exchange for “good” securities.

What happens to customer deposits when a bank becomes insolvent? Legally, deposits are loans to banks, and depositors are creditors. In insolvency, depositors are only entitled to a share of the bank’s remaining assets, not return of their money. So depositors can lose some or all of their money. Rumors that a bank is insolvent can therefore cause bank runs. Deposit insurance schemes such as FDIC discourage runs by guaranteeing that most depositors will get their money back.

But it’s not just fractional reserve banks that can suffer runs. Any financial institution that has long-term assets and very short-term liabilities, or liabilities that can become payable without warning, is at risk of runs. Most of these don’t have central bank support or FDIC insurance. FTX wasn’t a bank, but it did experience a run. And because the run was triggered by fear that FTX was insolvent, FTX couldn’t persuade anyone to lend it the money to survive the run.

Was FTX already insolvent when the run happened? Yes. The ”liquidity crisis” that brought it to its knees was caused by its insolvency, not vice versa. Will depositors lose money? Almost certainly. FTX has a gaping hole in its balance sheet, and no one seems remotely interested in plugging it.

When the bottom has fallen out of your bucket, pouring more water into it won’t fix it. It will just waste water. Nonetheless, if you can find a reliable source of water, you can continue to give the impression that your bucket is sound. Similarly, insolvent companies can continue to trade if they can persuade enough people to part with their money (yes, I know, this is illegal but it nevertheless happens). Too many trusting souls have been lured by promises of high returns into handing over their life savings to insolvent companies.

So it’s important that anyone thinking of putting money into a crypto company does due diligence. Don’t trust, verify.

The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.


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